Loan Review – September 2018

Monthly Commentary

When we last spoke, it was almost a certainty that loans would widen in September.
Why? In July, the new issue calendar overwhelmed the loan market, pushing new issue
spreads 90 basis points wider than issuance in May – 90 basis points! In August,
new issue volumes were quite low and the market still largely traded sideways … and
in September the loan market was going to have to digest over $45 billion of gross
issuance and over $20 billion of net new issuance including three mega LBOs, totaling
over $16.3 billion.

Well, much to our chagrin, this nearly certain event did not occur. In fact, the entire
month became quite ludicrous. The mega deals, which were in no position to
negotiate, all became quickly oversubscribed. One such deal, which shall remain
nameless, had so many adjustments to EBITDA that when the first covenant
compliance hits sometime in 2019, the company could be bleeding cash and still well
in compliance. Once it was evident that these deals were going to clear easily, and
the watermelon was being digested by the snake, secondary loan prices began to grind
higher… and higher.

The lack of discipline shown by investors in the primary market was confusing
because triple A spreads for CLOs have widened and CLOs have been the dominant
source of demand for the leveraged loans. If CLO demand was not overwhelming
the market, then what would allow the market to tighten while digesting $45 billion
of loans? Well, it is likely the less transparent demand came from SMAs (separately
managed accounts). Anecdotally, we have heard that massive amounts of money
came into the loan market from overseas, in the form of SMAs. This money needed
to be put to work and was willing to buy loans at any level. The result for the broader
loan market was less positive, leading to weakened credit agreements, tighter spreads
and higher prices.

Now, as we begin October, there is little new issue projected until Q1 2019.
Conventional wisdom would suggest the loan market will likely go through a pretty
large repricing wave as nearly 65% of loans trade above par.

Performance

In September 2018, the Credit Suisse Leveraged Loan Index (“CS LLI”) and the S&P Leveraged Loan Index (“S&P/LSTA”) were up
0.68% and 0.69%, respectively.

Year-to-date, ending September 30, 2018, the CS LLI was up 4.32% and the S&P/LSTA was up 4.03%.

For the 12 months ending September 30, 2018, the CS LLI was up 5.58% and the S&P/LSTA was up 5.19%.

Triple C and split single B led all categories in the month while double Bs were the worst performing category. Lower dollar priced
loans had the best performance and that is why loans split single B or below almost doubled or tripled the returns of double Bs
for the month.

Total Return by Rating

Source: Credit Suisse Leveraged Loan Index

Sector Performance

Nineteen of the 20 sectors in the CS LLI provided positive returns during the month. The top performing sectors in September
were Consumer Durables (+2.00%), Energy (+1.16%) and Retail (+1.08%). Retail has been driven the last several months by
generally good quarterly results as well as the outperformance and compression of higher beta stressed borrowers. Consumer
Durables has been led by the bankruptcy filing by Mattress Firm and the subsequent loan price rally in Serta (the largest consumer
durable company in the index).

The worst performing sectors for the month were Gaming/Leisure (+0.52%), Service (+0.50%) and Metals/Minerals (-0.24%).
Gaming/Leisure, which is largely viewed in loans as a more defensive/par sector, saw some weakness in the underlying equities
as investors began to question the discretionary nature of the category. As a result of the current trading levels and the equity
weakness, it lagged the broader Index.

In the last 12 months, Retail, Energy and Metals have led all sectors with total returns of 9.60%, 9.40% and 8.71%, respectively.
In contrast, Food/Tobacco, Consumer Non-Durables and Consumer Durables were the worst performing sectors with returns
of 4.40%, 3.81% and -0.36%, respectively.

Average Loan Flow-Name Bid

Source: LCD, an offering of S&P Global Market Intelligence

Technical Conditions

Leveraged loan funds reported an inflow of $1.29 billion for the rolling four-week period. This took assets under management
for the dedicated loan mutual fund base to $152.1 billion, which compares to the all-time high of $153.7 billion, set in April 2014.
Inflows year-to-date for loan mutual funds have totaled +$15.5 billion.

Gross U.S. CLO activity in September was approximately $17.5 billion, which includes $8.5 billion of new issue excluding refi/
reset/re-issue activity. YTD net new issue volume totals $101 billion with three months remaining in the year. At that pace, 2018
may indeed break the all-time record of $124 billion for annual CLO issuance, set in 2014. The S&P monthly net CLO issuance
can be seen below.

CLO Volume

Source: LCD, an offering of S&P Global Market Intelligence

Institutional new issuance increased $27.3 billion from August to $38.5 billion in September. On a year-to-date basis, institutional
new issue is down 11.3% from the first 9 months of 2017.

Leveraged Loan Volume

Source: LCD, an offering of S&P Global Market Intelligence

LBOs, acquisitions and mergers dominated the landscape in September, representing 83% of all issuance. Repricings represented
less than 10% of total new issuance, continuing a trend which saw repricing virtually disappear post May 2018.

U.S. Leveraged Loan Repricing Volume

Inflows and Rolling LTM Returns

Source: LCD, an offering of S&P Global Market Intelligence

September saw new issue spread widen month over month. However, this is deceptive. The original price talk on deals began
50-75 basis points wider than where deals actually priced. Dealers expected to need to add a material premium on September
deals in order to get them placed. As mentioned previously, that did not occur. On a year-to-date basis, new issue spreads in
September were 17.4% wider for double Bs and 2.9% tighter for single Bs. Again, in the early days of October we have seen BB
spreads tighten dramatically. Spreads during the last 12 months have traded in a range that was at its tightest between January
2018 and May 2018. The spread for the CS LLI ended September at roughly L+347 basis points. This is comparable to spreads for
the last five months, which have been the tightest for the CS LLI since September 2010.

New Issue Spread Changes

Source: LCD, an offering of S&P Global Market Intelligence

In terms of new issue yields, double B yields widened 8 basis points while single Bs tightened -37 basis points, month over month.
On a year-to-date basis, double B yields and single Bs are 159 and 113 basis points wider. Most of this increase in yield was driven
by 3-Month LIBOR as it was up 70 basis points during the year.

Average New Issue Yields

Source: LCD, an offering of S&P Global Market Intelligence

There were no defaults in September and the rate declined from the prior month to 1.81%.

The last 12-month default tally for the S&P/LSTA is 18. Oil & Gas defaults lead all categories with six while Retail is close behind
with three.

Lagging 12-Month Default Rate

Valuation

Since 1992, the average 3-year discount margin (“DM”) for the CS LLI is 460 basis points. If the global financial crisis (2008 &
2009) is excluded, the 3-year discount margin for the CS LLI is 416 basis points. At month end, the 3-year DM, at 381 basis points,
is at its tightest level since October 2007.

The DM spread differential between double Bs and single Bs has widened from October 2017 to September 2018 by 10 basis
points and is still 41 basis points wider than the historical spread differential.

3-Year Discount Margin Differential Between BBs and Single Bs

Source: Credit Suisse Leveraged Loan Index

Summary & Looking Forward

As of September 30, the S&P/LSTA Index imputed default rate was 1.15% and with the exception of April 2018, this was
the tightest level since October 2007.

Loan prices and spreads tightened in September and the 3-year discount margin ended the month at the tightest level since
October 2007. The loan market sits on the precipitous of another repricing wave, which could take us to the tightest levels seen
since PRIOR to the global financial crisis.

CLO triple A liabilities are still widening while we see loan collateral prices tighten. The arbitrage is already stressed and every time
we see rates go higher, the asset class seems to get incremental inflows from retail funds and SMAs, which only further pressures
the arbitrage. Something will have to give. We will either see triple A CLO liabilities begin to tighten again or we will need to see
enough outflows in loans that it restores the supply/demand relationship necessary to print new CLOs. However, when CLOs
have represented roughly 60% of the loan demand, it is hard to craft a scenario where SMAs and retail funds can replace that
demand for a prolonged period of time.

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